A declining real estate market is a difficult market to invest in. One of the most troubling, and least discussed, problems is that of false demand. This distorts the real picture of the local real estate market. Investors need to be aware of the false demand that exists in the local market they are looking at, and impact it can have on their ability to make money.

One measure of any area's real estate market are "comps" - comparative sales within a recent time period. Comps are generally used to determine, in a particular market, if the asking price of a property is realistic price. For investors comps have a double attraction - they are usually the basis of determining what a property can sell for in the near future, and sometimes what rents may be charged.

But there is a problem with comps in a declining markets. And this a big concern in parts of Florida, Arizona, Nevada, and California (to name a few). Investors and absentee/foreign owners have moved into severely depressed areas looking to pick up bargains. Both groups, sometimes one person is both, create a "false demand" in the markets. This really invalidates the use of comps, and it distorts the price signals that investors need to use.

While investors and absentee/foreign buyers have the same initial effect, their reasons for getting into these markets and their ultimate effects, are slightly different.

Investors come into the declining markets looking for inexpensive properties to generate income. The inexperienced investor gets caught up in the dramatic fall in value, seeing "bargains" everywhere. This is strengthened by the sales pitch that "the market has hit bottom" or "things are turning around". The investor doesn't do the numbers, or uses the wrong numbers (i.e., last year's rates), and buys into a depreciating asset. Almost immediately it is apparent that the property won't cash flow, can't be resold at a profit, and is too expensive to hold.

Aside from the problems faced by the investor/purchaser, this sale just became another "comp". It validates, in theory, that properties of that particular type are selling within a price range. This investor has helped distort of the perceived value of the similar properties. Other investors respond to such signals and buy at or close to this false price, potentially exposing themselves to loss.

The absentee/foreign buyer is slightly different. Unless this person/family/company is acting as an investor, there is no concern for immediate cash flow. Most absentee/foreign buyers are looking for second homes in the southern United States. In Florida it's New Yorkers, Canadians, Brits, and Germans. In Arizona there are a large number of Canadians bargain hunting. Wealthier people from South and Central America are moving in. Another wave of Asian buyers have arrived on the west coast.

These absentee/foreign buyers just buy and hold. They pay their bills and usually don't worry about cash flow or short term resale. And they are often flush with cash, purchasing properties for cash and with no mortgages. They also respond to comps and the attractiveness of "bargains", but they do not affect them significantly after their purchase. Maybe a bit of buyer's regret, but not a lot.

And the absentee/foreign buyers contribute to the false demand, distorting the market once again. And these buyers are not a very reliable source of consistent demand. Changes in currencies (such as the drop in the US dollar) can have a dramatic impact on foreign buyers. Should the US dollar jump in value, these buyers could vanish. A downturn in the US economy as a whole may dry up the pool of northerners who can afford second homes in Nevada.

It is important that investors are aware of and looking for signs of the false demand that appears in declining real estate markets. Too much reliance on recent comps, without understanding the overall market, can be treacherous. A bit of detective work may be called for. For example, how many absentee or foreign buyers has the local realtor dealt with or sold to recently?

Now, it may be possible to exploit this situation to find buyers for properties. Inexperienced investors or absentee/foreign buyers may buy based on some pretty numbers that you can pull up on a property you are willing to flip. We have been in that position and declined to pursue that option. Integrity in the process, buying or selling, has always been more important - in our business, happiness, and ultimate bottom line.

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